U.S. Mortgage Crisis Rivals S&L Meltdown

Toll of Economic Shocks May Linger for Years; A Global Credit Crunch

The home has long been the bedrock asset of most American families. Now, its value has become the biggest question mark hanging over the global economy and financial system.

Over the past decade, Wall Street built a market for more than $2 trillion in securities sold globally and backed by loans to U.S. homeowners on two long-accepted beliefs and one newer one. The prevailing logic: The value of the American home would never fall nationwide, and people would almost always make their mortgage payments. The more recent twist: Packaging mortgage loans and turning them into securities would make the global economy more resilient if anything went wrong.

In a matter of months, though, much of the promise of the new financial architecture -- together with its underlying assumptions -- has proven to be a mirage. As house prices fall and homeowners default on mortgages at troubling rates, the pain has spread far and wide. An examination of the resulting crisis shows that it is comparable to some of the biggest financial disasters of the past half-century.

So far, the potential losses look manageable compared with the savings-and-loan crisis of the 1980s and the tech-stock crash of 2000-02. But the housing debacle could yet take years to work out, thanks to the sheer complexity of it. Until the mess is cleaned up, investors will remain jittery and banks will likely hold back on all kinds of lending -- a credit crunch that is already damping global growth and could tip the U.S. economy into recession.

The new financial system -- shifting risk from banks to securities markets -- has worked "pretty well" up until now, says former Federal Reserve Chairman Paul Volcker. "We're going to find out if it works well for a major-league crisis."

To ease the pain, the Federal Reserve has cut short-term interest rates twice and is expected to cut them further tomorrow. The Bush administration has also pressed for private-sector curative measures. First, it urged big banks to create a new entity to buy some mortgage-linked securities that don't have a ready market now. And a plan finalized last week calls for freezing interest payments on perhaps hundreds of thousands of qualifying homeowners whose mortgage notes are set to rise. (See a primer: Will the Rate Freeze Help You?) Both ideas are controversial. They are hailed by some as well-conceived financial first aid and criticized by others as inadequate -- or an impediment to crisis resolution.

Veteran financiers see in the current episode a pattern consistent with classic financial manias: Investors' enthusiasm for an asset -- in this case U.S. houses -- drove up prices, attracted more capital and lifted prices to levels that preordained a fall. Home prices rose sharply elsewhere, too, including in the United Kingdom, parts of continental Europe and Australia. "Old fogies like me expected the bust to come earlier than it did," says George Soros, the 77-year-old chairman of Soros Fund Management. "A lot of us got tired waiting for it."

The Extent of the Crisis

The ultimate extent of the crisis will depend largely on how steeply the price of the average American home falls. That will play a pivotal role in determining how many people are at risk of foreclosure as payments on adjustable-rate mortgages tick upward and in the size of losses on securities backed by those loans. It will also affect the size of the hit that consumers sustain to their spending power.

House prices are down by 0.5% to 10% now, depending on the measure used. If they fell 30% -- what it would take to restore their historic relationship to inflation, rents and incomes -- $6 trillion worth of housing wealth would be wiped out. Measured against the size of the U.S. economy, that is less than what was lost in the stock market between 2000 and 2002. Initial guesses at total losses on subprime and similar mortgages range from $150 billion to $400 billion.

The latter figure would equal about 3% of U.S. annual economic output. That is similar to the losses suffered by S&Ls and commercial banks between 1986 and 1995. But it is less than half the scale of Japanese bank losses in the wake of that country's burst stock and real-estate bubbles.

The current crisis, though, differs in crucial ways from the recent tech-stock bust and the S&L crisis.

For one, it centers on assets -- houses -- that, unlike stocks, most people have bought with borrowed money. On average, mortgage debt amounts to nearly half the value of houses. In recent years easy credit has allowed many to borrow up to the full value of their homes, making them more leveraged than any hedge fund.

As prices fall, people who find themselves owing more than their homes are worth are much more likely to renege on their mortgages, leaving lenders to sell the foreclosed houses at a loss. To make matters worse, payments on more than $500 billion in mortgages will reset in 2008, mostly to higher rates.

Banks are far less exposed to serious damage than during the 1980s. Nonetheless, the shift of loans from banks to markets has created a staggering complexity that threatens to prolong the crisis.

During the Latin American debt crisis, the Fed and U.S. Treasury were able to prod a few hundred banks to renegotiate billions of dollars in debt owed by a few dozen developing countries. "You had uncertainty in valuation, but it was more straightforward: You know how big the debt is, you know who has it, a relatively small group," says Mr. Volcker. "This is much more complex."

Mortgages today are dispersed among banks as well as more than 11,000 investment pools, each of which may have hundreds, if not thousands, of investors. Many of those pools have been further repackaged into specialized funds known as structured investment vehicles and collateralized debt obligations, or SIVs and CDOs -- each of which have their own investors. That makes determining who owns the securities, what they are worth and the nature of the underlying collateral a tricky process.

David Barse of Third Avenue Management LLC, a New York investment firm specializing in distressed companies, is steering clear of CDOs for now. He says he would need to hire new experts just to figure how much they are worth. "We don't have the analytical systems to break them down," he says.

Indeed, coming up with a value for a CDO entails analyzing more than 100 separate securities, each of which contains several thousand individual loans -- a feat that, if done on any scale, can require millions of dollars in computing power alone.

Recent deals, such as a hedge fund's purchase of the mortgage portfolio of E*Trade Financial Corp., suggest markets are starting to sort things out. But many investors are hanging back, prolonging the uncertainty over markets and the economy.

Housing fits a pattern Mr. Soros has observed since he entered the investment business in the 1960s. Economic fundamentals, he posits, are supposed to determine asset prices. But often a flood of capital makes an asset's fundamentals seem sounder than they really are, attracting even more capital. "Eventually, you reach a turning point," he says, "where the value of the collateral begins to decline, which reduces the willingness to lend, which reinforces the fall in the value of the collateral."

"There usually has to be a flaw in people's perceptions to set a boom-bust sequence into motion," Mr. Soros says. In the case of housing, he says, it was the assumption that, because home prices fall nationwide only in a severe economic slump, a diversified portfolio of U.S. mortgages made for a very safe investment.

Robert Shiller, a Yale University economist who has made a career out of studying bubbles, says the last bear market in stocks may have also made houses more appealing. A 2003 survey of home buyers he conducted with a colleague found 10 times as many said the stock market's collapse encouraged them to buy a home as said it discouraged them. Their thinking, Mr. Shiller says, went like this: "I'm fed up with the stock market, I had so many promises of high returns and my broker and the accountants were deceiving us. But homes have always gone up in value, and it gives me great satisfaction to own a home and I can see it everyday."

At first, home prices rose for good reason. With the economy in recession, the Fed slashed interest rates in 2001 and kept them low until mid-2004. That, plus an influx of foreign savings to the U.S., kept mortgage rates low. Former Fed Chairman Alan Greenspan frequently argued there could be no housing bubble. The high cost and inconvenience of moving "are significant impediments to speculative trading and...development of price bubbles," he said in late 2004.

But rising home prices may have given both buyers and lenders a false sense of the market's stability and security.

Chris Delzio, a securities broker in the pricier New York area, moved to Palm Bay, Fla., in 2003 and bought two town houses, each for $75,000. Within two years, he had sold both for double what he paid and plowed the profits into land to build five new homes. Compared to staring at a securities-trading screen, he says, "It was fun, driving around, looking at the properties. You're out, talking, negotiating."

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